Subprime Securitization: How Much Spillover?

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As fallout from the subprime mortgage meltdown continues, the securities propped up by homeowners’ debt now sit on wobbly ground. Defaults by homeowners mean that the mortgage repayments they owe — which had been securitized (for the most part, chopped up and sold to new investors as bonds) — must be bought back, straining the securitization market.

Some economists reflexively wonder whether the woes of the subprime housing market will spread among such neighboring sectors as auto loans. And others worry if a similar contagion might eventually infect securitization markets generally.

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The Bank of England recently expressed the latter concern in its financial-stability report, which suggests that America’s subprime woes “give insight” into potential problems in markets such as corporate credit and commercial real estate. A strong appetite for securitized assets introduced weaker lending standards into the subprime housing market, and could potentially do the same elsewhere, the report said.

Where else might the subprime crash be replicated?

Larry Fink, CEO of BlackRock, a fund-management group, warned in a recent Financial Times interview that the leveraged loan market could be next. The UK report observed that if asset performance declines, then corporate lending standards could tighten. Higher standards could scare off managers of collateralized debt obligations (CDOs) and hedge funds that bank on the riskier tranches. A subsequent drop in demand would likely make the cheap debt they depend on much more expensive. As bond spreads fell in the past year, highly rated debt became scarce, with junk debt left behind to underwrite riskier deals.

“When you have these types of markets, people tend to get nervous,” says Michael Mascarenhas, vice president and senior analyst in the banking division of the Moody’s Investors Service ratings agency. “The appetite reduces and you see tightening.”

So far, any contagion largely has been contained, although “there are some investors losing money because of these mortgages,” according to Michael Fishman, a finance professor at Northwestern University’s Kellogg School of Management and co-editor of the book A Primer on Securitization.

Subprime lending is only one slice of the housing-loan pie, even though defaults and delinquencies on subprime loans have been occurring at a breakneck pace. In 2006 subprime mortgages comprised nearly 20 percent of new home loans, according to the Mortgage Bankers Association, which represents the real estate finance industry. And of that, 13 percent were delinquent after 12 months, according to rating service Standard & Poor’s. Two-thirds of mortgages are securitized.

And some see little chance of spillover. “It’s a different clientele,” says Brian Harris, senior vice president of real estate finance at Moody’s. “Subprime auto is much different than subprime residential, where the financial strength of the borrower is much lower.” Other securitization markets could be protected because of the abundance of liquidity in the world’s capital markets, in the view of Andrew Davidson, president of Andrew Davidson & Co., an investment-management consultancy. “There’s no shortage of investors right now,” he says.

But the containment may not last forever, other experts caution. Credit cards and automobile markets might also face pressure, Kellogg’s Fishman says, as the same people struggling to pay back loans on their houses — and unable to use them as collateral for more borrowing — also may fail to pay off credit-card and car debts. “The people who tend to default on one tend to be the people who default on the other,” he notes.

The most likely spillover may be seen among CDOs, which are closely tied to the subprime real estate market. The strain on the subprime securitization could reduce the investor base for CDOs, as defaults lead ratings agencies to change their criteria. Of course, CDOs and securitizations already bear part of the blame for the subprime problem. “Some combination of the way the securitization market worked for subprime and the way the CDO market worked allowed these instruments to trade at values above what they were really worth,” according to Davidson.

As the Bank of England’s financial-stability report sees it, reliance on leverage in subprime commercial real estate and corporate credit markets could “magnify the market response” in the event that their underlying assets stop performing. However, corporate loans are less driven by demand than mortgage-backed securities, and they are more diversified in terms of their exposure to risk. Since the deals are generally bigger, credit analysis in corporate lending tends to face tougher scrutiny.

Subprime loans do face a steeper threshold now. At a hearing before the Senate Banking Subcommittee on Securities, Insurance, and Investment, David Sherr, the managing director and global head of securitized products at Lehman Brothers, said that subprime borrowers are facing stricter guidelines and are being contacted if a default seems imminent. Not only are standards rising, he said, but the volume of securitizations and the range for mortgage products are shrinking.

“Mortgage finance tends to be cyclical,” says Moody’s Harris. “And the corrections in subprime tend to be more severe.” The structural differences between subprime mortgages and other sectors so far may have helped prevent spillover into other securitization markets. But companies and investors also may take a closer look at underlying asset quality, the bedrock of an investment, in light of the subprime crash.

If such assets are overvalued, any underlying investment — whether composed of bricks and mortar, or plastic — well could collapse.